Employee Benefits Legal Alert

Final Catch Up Regulations Issued

On July 7, 2003, the Internal Revenue Service issued final regulations for providing catch-up contributions to individuals age 50 or older. In doing so, the IRS made certain revisions to the proposed regulations that were issued in October 2001, including revisions to reflect the changes made to Code sections 414(v) and 402(g) by the Job Creation and Worker Assistance Act of 2002 ("JCWAA"). The final regulations are applicable to contributions in taxable years beginning on or after January 1, 2004, and may be relied on currently as well. (See, our November 2001 Legal Alert posted on www.kilpatrickstockton.com for a discussion of the proposed regulations.)

Congress added Code section 414(v) as part of the Economic Growth and Tax Relief and Reconciliation Act of 2001 ("EGTRRA"). This provision allows certain retirement plans that provide for elective pre-tax deferrals to permit participants to make additional deferrals that exceed an otherwise applicable limit and that are treated as "catch-up contributions" under the plan. However, a catch-up contribution cannot exceed the maximum amount of catch-up contributions permitted for the taxable year. (For the 2003 taxable year, the applicable limit is $2,000.) A participant is eligible to make a catch-up contribution for a taxable year if the participant would attain age 50 or older before the end of the taxable year. For non-calendar year plans, a participant is treated as eligible to make a catch-up contribution beginning on January 1 of the calendar year that includes the participant’s 50^th birthday without regard to the plan year. A section 401(k) plan, a section 408(p) SIMPLE IRA plan, a section 408(k) simplified employee pension, a section 403(b) plan or contract, and a section 457 eligible governmental plan may all offer catch-up contributions to their participants. However, a plan is not required to offer catch-up contributions, even if it otherwise provides for elective deferrals.

The final regulations retain the same basic structure for determining catch-up contributions as provided in the proposed regulations. Elective deferrals made by a catch-up eligible participant are treated as catch-up contributions if they are not in excess of the catch-up dollar limit and if they exceed an "applicable limit." The "applicable limits" consist of (a) a statutory limit (e.g., the annual deferral limit under Code section 402(g), which is $12,000 for 2003), (b) an employer-provided limit based on the terms of the plan (e.g., a limit on deferrals of 15% of compensation) and (c) the actual deferral percentage (ADP) limit (for section 401(k) plans only).

As in the proposed regulations, the final regulations provide that the amount of elective deferrals in excess of an applicable limit is determined as of the end of a plan year by comparing the total elective deferrals for the plan year with the applicable limit for the plan year. Under the proposed regulations, a catch-up eligible participant was permitted to make additional deferrals on a payroll-by-payroll basis, but the plan could not designate these elective deferrals as catch-up contributions until the end of the plan year. A number of commentators suggested that plans that provide for payroll-by-payroll limits be permitted to designate catch-up contributions based on the period for which the limit is applied. After considering these comments, the Treasury determined that the payroll- by-payroll method would create too much potential for abuse (e.g., ADP testing could be distorted through changes in plan limitations during the year), and therefore retained the annual method in the final regulations. However, the final regulations have expanded the use of alternative methods to determine employer-provided limits. Based on this expansion, plans that use different definitions of compensation for elective deferrals and for ADP testing will not be required to maintain data under both definitions. Furthermore, the final regulations retain the rule in the proposed regulations permitting a plan that changes an employer-provided limit during the plan year to use a time-weighted average of these limits as the employer-provided limit.

The final regulations provide that once an elective deferral is treated as a catch-up contribution it is disregarded for the following purposes:

• The annual limits on deferrals under Code sections 402(g), 402(h), 403(b) and 408.
• The Code section 415 limit on annual additions.
• For 401(k) plans, calculating the actual deferral ratio for ADP testing.
• The top-heavy rules under Code section 416. (However, catch-up contributions for prior years are taken into account in determining whether a plan is top-heavy).
• The minimum coverage requirements of Code section 410(b). (However, catch-up contributions for prior years are taken into account for purposes of average benefit percentage testing to the extent prior years’  contributions are used.)
• The requirements of Code section 401(a)(4) (e.g., a plan does not fail Code section 401(a)(4) merely because it permits only catch-up eligible participants to make catch-up contributions).

Although catch-up contributions are disregarded for the purposes listed above, catch-up contributions remain elective deferrals and are treated for plan purposes as any other elective deferral contribution. For example, catch-up contributions are subject to the distribution and vesting requirements of Code section 401(k). However, an employer is not required to provide matching contributions based on catch-up contributions. In the preamble to the final regulations, the IRS stated that employers can achieve this goal by specifying which contributions will be matched, rather than specifying which contributions will not be matched. For example, a plan can specify that matching contributions will be made based on elective deferrals that do not exceed a stated percentage of compensation, that otherwise do no not exceed a statutory limit and that matching contributions in excess of the ADP limit will be forfeited. In this case, matching contributions would not be made on catch-up contributions because the match-eligible contributions do not include contributions that exceed any of the three "applicable limits."

A critical provision of Code section 414(v) and the final regulations is the "universal availability requirement." The final regulations provide that a plan fails to comply with the universal availability requirement unless the plan provides all catch-up eligible participants with the same "effective opportunity" to make catch-up contributions. For this purpose, all plans maintained by employers within the same controlled group are treated as a single plan. As under the proposed regulations, the final regulations also provide that a plan (that otherwise offers catch-up contributions) does not provide an "effective opportunity" to make catch-up contributions unless the plan permits each catch-up eligible participant to make elective deferrals during the year up to the otherwise applicable limit plus the catch-up contribution limit. In the preamble, the IRS provided that plans that limit elective deferrals on a payroll-by-payroll basis may also provide participants with an opportunity to make catch-up contributions on the same basis (i.e., by allowing a pro-rata portion of the catch-up limit throughout the year), even though these deferrals would not be designated as catch-up contributions until the end of the year.

During the regulatory process, various commentators sought certain exceptions to the universal availability requirement. Based on these requests, the IRS in the final regulations adopted the following exceptions to the universal availability requirement –

• Employees listed in Code section 410(b)(3) (e.g., collectively bargained employees, non-resident aliens  and certain airline pilots) are now excluded from the universal availability requirement. This means that  employers are not required to extend catch-up contributions to collectively bargained employees, even if  the employees participate in the same plan (or another plan in the same controlled group) together with  non-collectively bargained employees.
• A plan may restrict catch-up contributions under a cash availability limit (i.e., a limit that restricts elective  deferrals to amounts available after deduction for applicable withholding taxes) without violating the  universal availability requirement. This means that a plan does not have to make catch-up contributions  available to a participant beyond a stated percentage of compensation. For this purpose, a limit of 75% of  compensation or higher will be accepted by the IRS.
• A plan may apply different employer-provided limits to different groups of employees without violating  the universal availability requirement. However, a plan may not provide a lower employer-provided limit  to catch-up eligible participants.
• The final regulations leave unchanged the exception granted to Puerto Rico plans by IRS Notice 2002-4.  In this regard, the preamble notes that plans that are qualified under the Code will not fail to satisfy the  universal availability requirement solely because another plan of the employer that is qualified under  Puerto Rico law does not provide for catch-up contributions.

However, the IRS did not adopt other suggested exclusions to the universal availability requirement. For example, a proposed exception allowing a service requirement for catch-up contributions that exceeds the regular service requirement under the plan generally and a proposed exception for participants in different qualified separate lines of business were not adopted by the IRS because these proposed exclusions were based on plan design and testing choices.

In general, the final regulations provide that the dollar catch-up limit applies to an individual across all retirement plans of the same controlled group in which the individual participates (with section 457 plans being tested separately). This means that if an individual participates in more than one plan sponsored by an employer / controlled group, the employer / controlled group must not allow catch-up contributions that, in the aggregate, exceed the applicable dollar catch-up limit.

The information contained in this Legal Alert is not intended as legal advice or as an opinion on specific facts. For more information about these issues, please contact the author(s) of this Legal Alert or your existing firm contact. The invitation to contact the author is not to be construed as a solicitation for legal work. Any new attorney/client relationship will be confirmed in writing. You can also contact us through our web site at www.KilpatrickStockton.com.